Banks consider SMEs to be core strategic businesses with a high profit potential.
To serve SMEs, banks are now establishing separate dedicated units, standardized processes, and risk-management systems.
The relationship manager’s role is crucial for attracting new customers, and selling products to existing SME customers.
Banks are increasingly serving SMEs through different transactional technologies. which emphasize cross-selling.
Large, multiple-service banks are the main players in the SME market.
A common perception is that small and medium-sized enterprises (SMEs) cannot access appropriate financing. This perception is often supported by academic and policy circles’ “conventional wisdom” that banks are generally not interested in dealing with SMEs, mainly due to SMEs’ perceived opaqueness1 and higher informality.2 As capital markets do not compensate for these deficiencies in the banking sector, the need to receive special assistance, such as government programs to increase lending, has been suggested.3 In recent years, SME financing initiatives included government-subsidized lines of credit and public guarantee funds.4
In the academic literature, there is evidence that banks (especially small and niche players) engage with SMEs through relationship lending. Relationship lending can overcome opaqueness due to the primary reliance on “soft” information gathered by the loan officer through continuous, personalized, direct contacts with SMEs.5 However, in a series of studies recently conducted by the World Bank, new stylized facts point to a gap between the conventional view and the way banks are actually interacting with SMEs.6
First, new evidence suggests that most banks, including large and foreign banks, indeed serve SMEs, finding this segment very profitable.7 Second, different transactional technologies that facilitate arms-length lending (such as credit scoring and significantly standardized risk-rating tools and processes, as well as special products such as asset-based lending, factoring, fixed-asset lending, and leasing) are increasingly applied to SME financing (Berger and Udell, 2006). Third, banks try to serve SMEs in a holistic way through a wide range of products and services, with fee-based products rising in importance, placing cross-selling at the heart of their business strategy.
Under this new model of bank engagement with SMEs, larger, multiple-service banks exhibit, through the use of new technologies, business models, and risk-management systems, a comparative advantage in offering a wide range of products and services on a large scale, becoming leaders in this business segment.
New Business Model
Banks’ high level of interest towards SMEs has, consequently, brought major changes to business models. First, as SMEs have become a strategic sector, banks are changing their organizational set-up to approach and serve this segment efficiently. Two main structures can be broadly categorized. The first combines the work of a commercial and credit risk team established at headquarters, with relationship managers distributed throughout the branches. The second consists of business centers or regional centers that operate as mediators between headquarters and branches, with a team leader or regional manager who controls and trains the relationship managers of the corresponding branches. In addition, banks are establishing separate, dedicated units with new strategies to cater adequately for the specific needs of SMEs. These dedicated business units approach SMEs in an integrated way, offering them a wide variety of products and services, including both deposits and loan products. In this set-up, relationship managers (RMs) are instrumental in attracting new customers, and selling products to existing ones. RMs look for new clients and prepare the information of each SME that is presented at the regional centers or at headquarters. They develop a relationship with the client, and, in some cases, RMs are allowed to express their opinion, make recommendations, or even present the case to the credit committee.
Second, the new model serves SMEs at all branches, and with standardized processes, facilitating the reduction of the high transaction costs that dealing with each SME entails. In most cases, branches and headquarters complement each other and undertake different functions. The initial stages of granting loans to SMEs are decentralized in most banks, while later stages, such as risk analysis or loan recovery, are usually centralized. In addition, banks exploit the synergies of working with different types of clients. Using information from existing firm databases, such as credit bureaus, relying on existing deposit clients, and attracting clients with bank credit are also common approaches that banks use to identify prospective SMEs.
Third, regarding credit-risk management, banks are reorganizing their systems, with a greater degree of sophistication among international banks and the leading, large domestic banks. Typically, risk management is a process that is organizationally separated from sales, and primarily done independently at headquarters. In most large banks, credit-risk management is not automated. Furthermore, in most cases, credit-risk management involves a credit-risk analyst, who is in charge of conducting both qualitative and quantitative risk assessments on the SME. The quality rating of SME management and SWOT (strengths, weaknesses, opportunities, and threats) analysis are the main components of qualitative assessments, while the financial analysis and projections of the SME firm and the SME owner are the main quantitative assessments. Qualitative assessments usually include an analysis of the SMEs’ products, their demand and market structure, the quality of the owners and managers (including the degree of separation between management and owners), the degree of informality, the years of activity in the sector, and the vulnerability to foreign-exchange-rate fluctuations. Quantitative assessments entail an analysis of profitability, cash-flow generation capacity, solvency, quality of assets, structure of balance sheets, and global guarantees. Moreover, scoring models are still being developed, and primarily applied to small loans.
Monitoring of the credit-risk outlook is standardized at the majority of banks. Some monitoring mechanisms used frequently are preventive triggers and alerts automatically generated to signal the deterioration of the SMEs’ payment capacity. However, credit-risk monitoring still depends on the diligence of the relationship manager or the credit-risk analyst. Some banks use a system that allows different individuals to provide input on each enterprise (such as auditors, back-office staff, sales personnel, and risk analysts).
The business and risk-management models described above can be better pursued by large universal banks, especially foreign ones, which can be more aggressive in reaching out to SME clients, and are better suited to conduct lending based on automated scoring models for small loans (as they have the know-how and models to do so) and template-type rating systems for larger loans (based on streamlined, standardized versions of corporate rating).
SMEs interact with banks using a variety of products, mostly checking and savings accounts, as well as term loans.8 Furthermore, SMEs do not exclusively obtain financing via “relationship loans.” SMEs access financing products that do not depend on the bank processing soft information on the firm.9 An interesting finding is that the provision of loans through public programs or guarantees is low. The highest usage of public programs observed is in Chile, with 8% of SMEs reporting using them; other countries are reporting percentages of around 3% (World Bank, 2007a).
Nonetheless, while SMEs increasingly interact with banks to purchase a range of products and services, SMEs still appear unable to obtain access to crucial products such as loans secured by certain forms of collateral (for example, accounts receivable, inventories, equipment, cattle, and intangible assets), or long-term, fixed-interest rate loans in domestic currency. However, it is still unclear how much SMEs in developing countries would be able to rely on banks to obtain those products. As the US literature indicates (Carey et al., 1993; and Berger and Udell, 1996), SMEs might have to rely on private placements and non-bank institutions. Bank financing for certain SMEs, such as start-ups (in particular, those in high-tech or research-based industries), is also likely to remain limited, as has proven to be the case in developed markets such as the United States.
Government Interventions in Colombia10
While direct government funding programs have been described as relatively unsuccessful, policy innovations could still prove important for SME financing. For example, in Colombia, several policy measures targeted towards the micro and SME segments have been introduced since 2004. On the one hand, non-financial instruments have been implemented, including training programs to increase competitiveness, and promote technological development and exports. On the other hand, financial instruments have been introduced, including the further expansion of existing government programs, and promoting the development of alternative financing instruments (investment funds, factoring/supplier financing, fiduciary structures, etc).
Colombian government programs include long-term development funds and partial credit guarantees. Longer-term development funding is mainly provided in the form of rediscounting lines at below-market rates by the state-owned, second-tier credit institutions, Bancóldex,11 Finagro,12 and Findeter.13 Partial credit guarantees—typically around 50% loan-loss coverage—are provided by FNG,14 as well as by FAG15 for the agricultural sector. The role of these institutions—particularly Bancóldex and FNG—has been cited as instrumental in promoting access to credit for SMEs.
The authorities have recently embarked on an initiative to improve financial access, including for SMEs. The low level of financial penetration in Colombia, both in response to pre-crisis levels and in comparison to regional peers, has prompted the authorities to take measures to expand access to credit and other financial services. Both demand- and supply-side barriers have been identified, and will be tackled via regulatory reforms and the Banca de las Oportunidades initiative. Recent policy measures include the introduction of correspondent banking arrangements, changes in the definition of the interest-rate ceiling, the passage of legislation on credit reporting, and the strengthening of creditor rights via a new bankruptcy law. Additional proposed reforms include changes to the civil code on enforcement procedures and to the financial system structure, as well as plans for the introduction of a special savings account for low-income households. In addition, the Banca de las Oportunidades initiative aims to design and propose measures to stimulate financial access, particularly for low-income households.
In summary, the new evidence shows that the whole spectrum of private banks (large and small, domestic and foreign) has started to perceive SMEs as a strategic sector. Banks are aggressively expanding, or planning to expand, their operations in the SME segment. As a consequence, the SME market is becoming increasingly competitive, although far from saturated. The evidence suggests that banks are learning how to deal with SMEs, and, at the same time, making the investments to develop the structure to deal with a growing market in the years to come. As banks have recently discovered a key, untapped segment, it is likely that the models to work with SMEs will evolve significantly as the involvement with the SME segment increases.
However, there are issues that remain for future work. Although banks appear to have become more involved with SMEs, banks may not be able to measure comprehensibly their exposure to the segment in terms of income, costs, or risk. Furthermore, banks are not adequately tracking their loan-loss experiences. We might be witnessing a process in which banks are only now developing the structure to deal with SMEs, and, through their interactions with the segment, they will be able to reduce the involved costs and risks.
1 Opaqueness means that it is difficult to ascertain if firms have the capacity to pay (for example, viable projects) and/or the willingness to pay (due to moral hazard). For example, lack of audited financial statements prevents banks from engaging in what is known as financial-statement lending, by which the loan contract terms are set on the basis of the company’s expected future cash flow and current financial condition, as reflected in audited statements (see Berger and Udell, 2006).
2 If firms do not reliably report their full financial activity on their financial statements, banks do not count, for example, with complete information on warranties for lending. See OECD (2006) for more on the factors that drive SMEs to operate in the informal economy, especially in emerging economies.
3 The need to provide support to SMEs through critical government investments was stated at the World Economic Forum on Latin America Summit in 2008. In addition, re-examination of tax regimes, regulatory reforms, and provision of capital through public-private partnerships were mentioned. See WEF (2008).
4 Chile’s Fondo de Garantía para Pequeños Empresarios (FOGAPE) is a fund created to encourage bank lending to SMEs through partial credit guarantees. The Colombian Fondo Nacional de Garantías (National Guarantee Fund) provides similar partial credit guarantees. Structured finance transactions arranged by FIRA, a Mexican development financial institution focused on the agricultural sector, are another example of a government effort to provide financing to rural SMEs. Furthermore, the Mexican development bank, NAFIN, has initiated a reverse factoring program to provide working capital financing to SMEs through a process of online sale of receivables from large buyers. See de la Torre et al. (2007).
5 See DeYoung (2000), DeYoung, and Hunter (2003), Carter et al. (2004), and DeYoung et al. (2004) for a discussion of the comparative advantages that small community banks have in lending to small firms through relationship lending.
6 See de la Torre et al. (2008a, 2008b) for a comprehensive analysis. Case studies are also available for Argentina, Chile, Colombia, and Serbia, describing the institutional and macroeconomic contexts, their banking industries and trends, and the data in detail. See World Bank (2007a and 2007b) and Stephanou and Rodriguez (2008).
7 Using data from 91 banks in 45 countries, Beck et al. (2008) found that all banks in the sample have SME customers, over 80% perceive the market to be big and prospects to be good, and more than 60% have a separate department managing their relations with SMEs. On average, the share of bank loans to small (medium) enterprises averages 11% (13%), compared to 32% in the case of large firms. The share of non-performing loans for small (medium) enterprises is 7.4% (5.7%), compared to 4% in the case of large firms.
8 Banks have developed a wide range of fee-based, non-lending products and financial services for SMEs. Loans are not all always the main product offered to SMEs. Moreover, loans are often offered as a way to cross-sell other lucrative fee-based products and services. See de la Torre et al. (2008a, 2008b).
9 de la Torre et al. (2008b) argue that banks are developing new technologies and business models to serve the SME segment, reducing their dependence on “relationship lending” and the gathering of “soft” information, which is costly and time-consuming.
10 This case study can be found in Stephanou and Rodriguez (2008).
11 Bancóldex’s main aim is to provide low-interest lines of credit via first-tier credit institutions for exporters and SMEs.
12 Finagro’s main aim is to provide low-interest financing for agriculture, livestock, forestry, and related rural projects.
13 Findeter was set up in order to lend (via first-tier banks) to subnational entities for infrastructure and other development projects.
14 FNG is a guarantee fund that “backs” credits to all economic sectors (except agriculture) with the primary objective of facilitating access to credit for micro enterprises and SMEs.
15 FAG is a guarantee fund that “backs” working capital and investment loans for the agricultural sector that are financed either with Finagro discounting, or with a credit institution’s own funds.